Stocks or Bonds?

Good morning. It’s your weekly dose of TSP Talk.

Stocks or Bonds?

The good news from last week was that after some late selling on Friday afternoon, the S&P 500 did manage to end the week up about 0.5%. The bad news was that it started the week with a +3% rally on Monday, but spent the rest of the week giving most of that back.

I’m always a little leery of completely trusting past patterns to repeat themselves once we notice the pattern. That is, obvious patterns are easily recognizable when they are forming, but so often when we notice a pattern, it tends to end before we can take advantage. That said, it is hard not to pay attention when these patterns present themselves.

In the last year plus, we have seen about three bear market rallies that broke their rising trend, made a small push upward into resistance after the break down, saw a PMO sell signal when the indicator moved below its 10-day moving average, and eventually made another leg down in the bear market. We are now seeing the fourth such event.

Chart provided courtesy of www.decisionpoint.com, analysis by TSP Talk

Will it play out the same way, or is this another case where we notice a pattern, and then it ends? Of course we don’t know the answer to that just yet, but the writing is on the wall. It is also interesting to note that the first bear market rally breakdown started in late May of 2008 after making a temporary bottom in March of 2008. Does this mean we might see a pullback until mid-July, as we saw in 2008?

One of the clues to a possible correction in the stock market, it the action in the bond market – but more from a contrarian point of view. The 30-year Bond has been forming a very large descending wedge pattern since the peak in late 2008. Descending wedges are considered bullish patterns in that they tend to eventually break out to the upside.

Chart provided courtesy of www.decisionpoint.com, analysis by TSP Talk

So, here we have a 5-month long descending wedge, and the 30-year bond is at the bottom of the wedge near support. If this chart does break out of this wedge pattern on the up side, that means it will have to move above 125. Even if it doesn’t break out and just moves back up to test the upper end of the wedge, we are looking at a move up near 125.

There is a ton of negative sentiment surrounding bonds right now. Many believe interest rates will be moving higher in the near future which pushes the price of bonds (and the F-fund) lower. But we know that what the “many” believe will happen, is not usually what does happen.

Let’s take a look at a sentiment survey for the U.S. Long Bond:

The bullish percentage is down to 25%, an area where bonds have tended to rally in the past. Just like stock market sentiment surveys, bond surveys are contrarian indicators, meaning you want to do the opposite of what the majority says, when the readings are at extreme levels. You can see below that 80% of those surveyed in late 2008 were bullish on bonds, and bonds moved down sharply soon after.

Chart provided courtesy of www.sentimentrader.com

With only 25% of those surveyed being bullish on bonds now, it could be a good time to go against the majority and take a shot at the bond market.

And what would make bonds rally right now? Well, a sharp correction in the stock market would be my best guess.

Thanks for reading! The TSP Talk Market Commentary is updated daily on www.tsptalk.com.